Sunday, June 21, 2009

Mis-Adventures with Debentures

[Executive Summary: This is the fourth part of an irregular series of essays about the United States Dollar--what it really is, and what the boys in Washington are doing with it and will do with it.]

Imagine if you will if you had a bank, worth $1 billion--that being the amount out in loans today.

(Okay. As long as we're dreaming, I want a Maserati, Detroit Tiger season tickets, and a date with the first lady of France.)

But anyway...

For a billion-dollar bank, Federal law says you have to have the equivalent of $100,000,000.00 in funds in a vault. This is called your "reserve." You don't have $100 mil in real funds on hand; no bank (other than a Federal Reserve branch bank, which is a different critter) in its right mind keeps that kind of cash on hand.

They would have, however, other papers that are, or should be, worth $100 mil in its possession in order to stay in business. Such high value papers are called "Securities." Banks have to be very careful that their "securities" are "secure." Not just physically secure, but financially secure. For starters, the bank (generally) can't own stock. Bonds only. Furthermore, independent rating companies give the bonds ratings, starting from "AAAA" (U.S. Treasury notes) down to AAA, AA, A, BBBB, etc, down to D, which are wastepaper debentures (corporate junk bonds). Banks aren't supposed to have D bonds and if they do they don't count toward the reserve required.

What happened was this: imagine, if you would, if someone went into a bank with a magic wand, waved it three times, and said to the manager, "Yanno, those AAA bonds in your vault? They're now worthless--they're all junk bonds. I'm changing their ratings from AAA to D. And you can't use D bonds toward your reserve. So, your reserve just dropped from $150 million to $50 million. You're required by law to have $100 mil in the vault. Better do something quick or we shut you down!"

That "something quick" consists generally in calling in loans. Like RIGHT NOW. A bank can go to the "Fed" to get money out, but what happens if all the banks have this happen at once (like last September)? Everyone wakes up one morning and, if they're a banker, they have a nervous breakdown. Which is what happened in September.

Here's how it happened.

Now I'm no financial wizard, but here's a good explanation of where it started when what went wrong, went wrong. (Warning: it's uses naughty language and may not be safe for work.) It's a PowerPoint presentation that uses stick figures and funny dialogue to sum up the whole story.

Read it. Go ahead. I'll wait.

The CMOs didn't even need a downturn in housing prices to go bad. Housing prices just needed to go flat. And that was all it took.

With bankers and investors swearing at each other over the phone about the non-payments not being made, someone decided that the CDOs and CMOs were as crappy as the loans that underlay them. More specifically, happened on September 2008 was the after effect of someone at Moody's or one of the other bond-rating organizations, in April of 2008, doing exactly that, in their official capacity. (Without bothering with a magic wand.) They decreed that Collateralized Drawing Obligations, or "CDOs" and Collateralized Mortgage Obligations, or "CMOS" to be, not AAA grade investments, but D grade investments.

Poof. Zillions in reserve funds go bye bye. And they have to sell these CDOs and CMOs to boot. Which nobody will buy.

All of a sudden a WHOLE LOTTA BANKS have to come with money from SOMEWHERE to meet their reserves, or they shut down.

To do this, they have to stop lending money to anybody.... which is what happened. Nationwide, systematically, and overnight. It's as if a quarter-to-half-a-trillion dollars beamed up to the Enterprise, never to be seen again. (One friend of mine in DC tells me that CITIBANK's president was half an hour away from closing every CITI ATM and bank branch in the country at the time of the meltdown in September.)

And your average banker then asks: "WHADDAWEDONOW??!?".

So. A lot of really, really, really big banks bought a lot of these "CDOs" and "CMOs" These CDOs/CMOs were fancy paper wrapped around rotting fish heads which were the essentially worthless subprime mortgages they had been issuing for years.*

(*Small digression here. The bullshit subprime mortgages were issued by the banks with a gun held to their heads by the Federal government by means of the Community Reinvestment Act. However, these same banks which sold the mortgages at gunpoint cooked up the CDO's all on their own without any help from the Federal government.)

So. What we have here is the financial equivalent of this line from "Armageddon":

Imagine a firecracker in the palm of your hand. You set it off, what happens? You burn your hand, right? You close your fist around the same firecracker, [clenches his hand into a fist] and set it off. Your wife's gonna be opening your ketchup bottles the rest of your life.

Had they not cooked up the CDOs, they would have been out zillions of dollars (because the bad mortgages still would have been written off) BUT the economy's hand would have been (merely) burned. But by cooking up these CDOs, they turned what should have been a small disaster into something that almost caused the entire system to blow off its right hand--to almost completely self-destruct.

By another analogy: they took a pile of manure, froze it solid with cold air, then built a skyscraper on a foundation of that frozen manure, hoping to get rent from the skyscraper to pay for the manure. What happens to the skyscraper when summer comes and the manure melts? Building faw down go boom.

So who is at fault for our current mess?

Three groups: Congressional Democrats (in particular--Chris Dodd and Bawny Fwank) are at fault for forcing the banks to make these subprime loans to those who couldn't possibly have paid them back, without some sort of government guarantee (like USG Guaranteed Student Loans of the sort that got me through college and law school).

Second, The banking "geniuses" who cooked up the CDOs were at fault for knowingly creating the financial equivalent of a financial Chernobyl.

And third, Congressional Republicans then in power were absolutely at fault for (a) not catching this thing before it exploded and (b) for deliberately not regulating the financial industry sufficiently to even catch it before it exploded.

So: Quo vadis, O Obamessiah? Where are we going now? Asking the wife to open our ketchup bottles? No? Stay tuned.

Next: Brother, can you spare 1,040,000,000,000 dimes?.

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